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Endogenous Regime Switching Near the Zero Lower Bound

Kevin Lansing ()

No 2017-24, Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: This paper develops a New Keynesian model with a time-varying natural rate of inter-est (r-star) and a zero lower bound (ZLB) on the nominal interest rate. The representative agent contemplates the possibility of an occasionally binding ZLB that is driven by switching between two local rational expectations equilibria, labeled the "targeted" and "deflation" solutions, respectively. Sustained periods when the real interest rate remains below the central bank's estimate of r-star can induce the agent to place a substantially higher weight on the deflation equilibrium, causing it to occasionally become self-fulling. I solve for the time series of stochastic shocks and endogenous forecast rule weights that allow the model to exactly replicate the observed time paths of the U.S. output gap and quarterly inflation since 1988. In model simulations, raising the central bank's inflation target to 4% from 2% can reduce, but not eliminate, the endogenous switches to the deflation equilibrium.

JEL-codes: E31 E43 E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cmp, nep-dge, nep-mac, nep-mon and nep-ore
Date: 2017-09-28
Note: An earlier version of this paper was titled "Endogenous Regime Shifts in a New Keynesian Model with a Time-Varying Natural Rate of Interest."
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DOI: 10.24148/wp2017-24

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